Wednesday, February 12, 2014

Optimal Cash Allocation for Dividend Investors

Many income investors I have gotten to interact with, seem to be struggling on the topic of what their optimal cash allocation should be. I am going to try and discuss this from my own experience of someone in the accumulation stage of the game.

High allocations to cash can be helpful in situations where markets are dropping. Purchasing attractively priced shares after a 10% - 20% drop in prices is much easier when you have a certain allocation of cash. However, if you have high allocations to cash, and prices keep rising, you have a high opportunity cost of this resource. The past five years have been brutal for those who have been waiting in cash, waiting for a huge correction, which never came. At the same time, the purchasing power of this cash is constantly decreasing, which is normal for cash.

In the current low interest rate environment, having a lot in cash would probably not generate much in income. In addition, investors would be losing out on potential for dividend compounding if they are not fully invested. If one finds Coca-Cola (KO) overvalued at 19 times earnings, or already has a full position in McDonald’s (MCD), they might decide to focus on a Philip Morris International (PM), Altria (MO) or Kinder Morgan (KMI) instead. One can always find attractively valued dividend stocks out there, as long as they keep looking.

In reality, investing cash as soon as it becomes available in companies which are cheap at the moment could be the most optimal strategy for investors. I find that hoarding too much cash in an effort to wait out until prices correct by a certain predetermined amount such as 10% - 20%, is similar to market timing. Based on numerous studies that have been conducted on investor behavior and performance, it is very safe to assume that for over 90% of investors out there, market timing is a losing proposition.

In general, it does not really make that big of a difference twenty years after the investment, if one purchased at the high for the year or the low, as long as they made the transaction. For example, in 1988, shares of Coca-Cola (KO) traded between a low of $2.20/share and a high of $2.80/share. Investors who didn't want to buy at 2.80/share because the price was “too high”, missed out on the rising stream of dividends that is still going on. While the results from investing at $2.20 and $2.80 are going to be different, the most important thing is to have purchased an asset like Coca-Cola and hold on for as long as it made sense. And Coca-Cola was certainly a good value in 1988, selling for somewhere between 12.20 and 15.80 times earnings and yields between 2.60% - 3.40%. One investor that took advantage of this hidden value was the Oracle of Omaha himself, whose holding company is earning an yield on cost of over 30% on their investment in the world's largest soft-drink maker.

Also in 1988 Bank of America (BAC) traded between $4.50/share and $7/share. Investors who purchased the stock at either the high or the low were much better off than those who held on to their cash and waited for a correction. Of course, if investors didn’t sell after the first dividend cut in 2008 however, they would not have had much to show for their investment. But selling your dividend stocks is not the topic of this article.

In my dividend portfolio, my cash allocation is somewhere between positive 1- 2% and a negative 1- 2%. I usually let dividends accumulate and then reinvest them in the best values at the moment. In addition, I typically try to add cash to my portfolio monthly. I accumulate the cash and then try to make purchases with the proceeds.

I get lists of attractively priced stocks by running my monthly screen on the lists of dividend champions and dividend achievers. As a result of my cash contributions every month, plus the addition of cash dividends from my accounts, I manage to purchase shares in anywhere between one and three companies. Sometimes however, a company that I have analyzed and liked, would get into value territory. My cash infusion might be a few weeks away, yet knowing that this opportunity might be short lived I might take action. One such example occurred in 2010, when Yum! Brands (YUM) announced a dividend increase that effectively put the stock at the 2.50% entry yield I require. I immediately jumped in, and bought a small position on margin. A few days later, my cash deposit and the dividends I received in the meantime increased my cash position above zero.

If stock prices were to fall precipitously from here, many companies which have been previously overpriced, would become cheaper. As a result, investors would be able to scoop up great businesses at depressed prices. Those who are still in the accumulation stage and deploy their cash every month will be able to take advantage of the opportunity and buy quality shares at a discount. More experienced investors might also decide to use margin and make investments, a few days or weeks prior to any planned cash deposits into their brokerage accounts. Investors who held some cash however, would likely be able to deploy a large portion of it in attractively valued stocks, provided that they do not freeze under fire, and provided that they do not wait for even lower prices that may or may not materialize. These are the investors who should carefully consider however the opportunity cost of holding that cash for extended periods of time waiting for a market decline, versus deploying that cash immediately.

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